As Inflation Looms, Real Estate Heads Into Long-Forgotten Territory
The last time anyone in real estate had to think too hard about inflation, the iPhone was a new invention that only a few people owned, George W. Bush was still president and the Kardashian family were only known for dad Robert’s involvement in the O.J. Simpson trial.
The year was 2007, and it was the last time inflation in the U.S. topped 4%, the kind of level that starts to really concern central banks and governments. Since the financial crisis, deflation caused by stagnant economies has been the worry.
“There’s probably a generation out there living in the world that don’t really know what inflation is, we haven’t had it in any meaningful sense since the [Great Financial Crisis],” JLL Chief Economist Ryan Severino said.
It's back. Last week, Warren Buffett predicted a “red-hot” spike in inflation as the U.S. economy recovers from the coronavirus, and the Bank of England predicted that inflation will rise beyond its 2% target as the UK also recovers strongly. Blackstone Chief Operating Officer and former Head of Real Estate Jon Gray said at an event last week he was more worried about the impact of the economy overheating and causing inflation than he was about a post-Covid slump back into recession.
Inflation can be good for real estate, in some cases very good. But it carries risks as well; there is "good" inflation and "bad" inflation. It can boost rents, but also raise interest rates. It will affect different sectors in different ways, and mean different things to different investors and developers.
But in the immediate term at least, real estate is going to have to dust off its manual of what to do in an inflationary economy and try to update it for a new world.
It is no surprise that the U.S. and UK are set for a jump in inflation above recent norms in 2021 and on into 2022. The Fed and the BoE are both predicting economic growth of 7% or more this year, as economies emerge from a deep sleep, with the economic amphetamine of fiscal stimulus in their systems.
“Economies have been like Sleeping Beauty for the last year, and that is deflationary,” CBRE Global Investors Global Chief Economist and Global Head of Real Assets Research Sabina Kalyan said. “In the U.S., people have had their stimulus checks, people have been saving,' Biden wants to build back better,' and that puts a lot of fuel into the economy. We were always going to get inflation above what we’ve been used to.”
Kalyan said that a period of above-average inflation after such a long period of low price growth, and even deflation, could provide a significant boost for economies and real estate. She said there was a historical parallel, but not the one people are usually evoking right now.
“People talk a lot about the Roaring '20s, but the economy was actually miserable in that decade in a lot of places,” she said. “I think a better comparison is actually the 1950s and ‘60s, when you had the post-war Marshall Plan, a lot of American money pouring into Europe, and you essentially saw the birth of consumerism as a result.”
That period had a dramatic influence on commercial real estate, in the UK at least, with the system of upward-only rent reviews in a lease having been designed to allow owners of property to benefit from inflation in office rents.
Kalyan and others said that while inflation will rise beyond central bank targets in the short term, perhaps reaching 3.5%, it is unlikely to stay there for long or go significantly higher.
“The pullback from globalization, with companies bringing their supply chain back on shore, may have the impact of raising prices as well,” Hong Kong-based Bei Capital founder Collin Lau said. “But in the medium term, three to five years, the demand drivers are not there for significant long-term inflation when it comes to consumer prices.”
So why the worry from the likes of Blackstone’s Gray, or former Treasury Secretary Larry Summers, who was warning about inflation risk as early as last year? Because high inflation for a sustained period can be highly detrimental to consumers and investors. If prices rise fast, then money is essentially worth less, eroding savings.
For real estate in particular, it can have a negative impact in the form of rising interest rates, the policy tool seen as the most important for central banks when it comes to combating inflation, because people tend to borrow and spend less and save more.
Historically low interest rates have been a huge windfall for real estate over the past 13 years. The fact that yields in the sector are at historic highs, compared to risk-free assets like government bonds, means real estate is highly appealing to investors looking for income. Any significant rise in rates to combat inflation has the ability to lessen that appeal. Investors might not be willing to pay such low yields to buy assets, so prices might fall.
That is not too big a worry yet — Lau pointed out that investor allocations for commercial real estate are still rising, as many institutional investors around the world still want to diversify their portfolios away from stocks and bonds, and real estate is seen as a asset class that mixes income and capital growth.
Kalyan said that there are different types of inflation, and different investors would react to them in different ways.
“It depends what causes it,” she said. “With the oil shock of the 1970s, then rates went up, that was tough for the economy. But if you have inflation for a good reason, because economies are growing, then that is different. Rates might rise, but if investors can see rents rising because the economy is growing, then they might be willing to pay the same cap rate.”
Portfolios can be structured accordingly: If an investor is worried about inflation, then it can structure a portfolio that takes that into account, with long leases and preferably upward rent reviews. If they aren’t, then crack on and invest in markets exhibiting cyclical growth.
In one area of real estate, inflation has been a given for some time now: Construction costs have risen 13% in the last year, according to Market Insider, with the price of lumber rising more than threefold as demand skyrockets and mills struggle to keep pace.
That price increase hasn’t hit existing projects too hard, because contractors have had to bear the brunt of contracts entered into some years ago, when prices are lower, and that cost hasn’t been passed on to developers — yet.
“There is a long lag time in the construction industry,” Associated General Contractors of America Chief Economist Ken Simonson said. “It’s too early to tell if the recent rises will start to be passed on [to developers] and what that does to the rents they need to charge.”
If costs do start being passed on, that could have the knock-on effect of limiting new supply of commercial space, benefiting existing owners.
Severino, JLL's chief economist, said that in previous cycles, real estate has been seen as a good way of protecting yourself against inflation as an investor: You get the benefit of rising rents that might offset any negative impacts in other asset classes in your portfolio. It is a message he thinks the industry can capitalize on in the current moment.
“There is a whole generation of people in CRE who have probably heard of [the sector being] a mythical hedge against inflation, but never seen it," Severino said. “But I still think it’s a compelling argument in terms of why you would own CRE.”
The sector was seen by investors as an inflation hedge in the 1970s, and the sector could be positioned so again.
“Even if it’s just marketing, the rationale still holds, and I think it would be a huge missed opportunity if real estate didn’t try and turn this into a beneficial situation," he said.
The sector has changed hugely since the last time inflation was a legitimate threat. Retail has been completely upended by e-commerce, and the office sector is going through its own moment of existential angst. The link between inflation and rent rises won’t be quite as straightforward as in the past.
“You might not see inflation in office rents in the same way anymore,” Lau said. “You only need people to work from home about 20% of the time to make an impact on office demand and rents.”
He added that the sector benefiting from growing rents now, like logistics, multifamily and life sciences, would be those that benefit in a more inflationary environment. Inflation is not a tide that will raise all boats.